Botoxed earnings and the Holy Grail defense
In public companies like Fannie Mae, earnings management is like skin care, smoothing out the wrinkles to present a shinier corporate image. Like skin care, it seems almost every publicly traded company uses it to some degree or another. As the New York Times puts it:
Beyond simple wrinkle cream lies botox — poisonous bacteria eating your face — whose effects are dramatic:
Worried about your stock options? Don’t be!
Botoxing can be applied to corporate earnings. As the Washington Post reports:
It begins with a number — say, $6.46.
That’s the figure Fannie Mae was shooting for after the company set a goal in 1999 of doubling annual earnings per share by the end of 2003. For employees, incentive pay was on the line.
The report, commissioned by members of Fannie’s board, says the board was essentially in the dark while improper accounting was inflating Fannie’s earnings by billions of dollars.
Equally troubling is that:
After 17 months of work, even the lawyers and accountants who labored to produce the report aren’t entirely sure what happened.
But some things came across loud and clear — like the number $6.46.
“You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts,” the former head of Fannie Mae’s internal audit unit, Sam Rajappa, said in a pep talk for internal auditors six years ago.
Earnings management would be one thing if it were being done disinterestedly — but it was not:
About five months before meeting with Ms. Spencer and Mr. Howard about the deferral, the report said, [extremely highly compensated (more than $20 million a year!) now-terminated CEO Franklin Raines] got a memo from Lawrence M. Small, then the president and chief operating officer, that emphasized that reaching Wall Street’s expectations was important for the bonus program, known as A.I.P., for annual incentive plan. The Wall Street forecast was for earnings of $3.21 a share in 1998 and $3.23 in 1999.
“For 1998, I’m reasonably confident there’s enough in the ‘non-recurring earnings piggy bank’ to get us to $3.21,” wrote Mr. Small wrote. “While that number should satisfy investors, you should be aware that last year the A.I.P. paid out just short of the maximum. This year, the maximum is $3.23, so at $3.21, the bonus pool will be noticeably lower than in 1997, a fact which will, of course, be rapidly observed by officers and directors come January.”
Top photo, earnings $3.21, bottom photo, earnings $3.23!
It would be one thing if the impacts were small — but they are not:
The report comes as Fannie Mae continues to struggle through the accounting scandal. The company has not filed an earnings statement since 2004. Later this year, it is expected to make a $11 billion restatement of its earnings going back to 2001. Still, shares of Fannie Mae rose 2.2% on Thursday amid relief that the report had concluded that many of the accounting and management problems were being resolved.
Earnings management can smooth away those nasty surprise lines
It would be one thing if the company were purely private, and hence only the shareholders were at risk — but they are not:
Randy Quarles, a Treasury under secretary, said the Rudman report exposed “earnings manipulation and a culture of earnings at any cost, and showed that the enterprise was not focused on its core housing mission.”
While he said the company had made significant progress in cleaning up its accounting and governance structure, it had not reduced the systemic risks posed to the economy by lax rules that enable the company to amass a huge investment portfolio. Fannie Mae and its smaller sibling, Freddie Mac, hold a combined portfolio of about $1.5 trillion.
“We may now have better accounting practices at the institution,” Mr. Quarles said. “But that doesn’t reduce the risk associated with size of their portfolios.”
In response, Fannie Mae has expressed contrition and made leadership changes:
We have put in place a new management team, with a new Chief Financial Officer, Controller, and Chief Audit Executive.
We may call this the Holy Grail opening titles defense:
We apologise for the fault in the
subtitles. Those responsible have been
sacked.
Mynd you, moose bites
We apologise again for the fault in the
subtitles. Those responsible for sacking
the people who have just been sacked,
have been sacked.
“It’s only a model.”
